Should You Buy Stanford Or Apple Bonds?

I have been following two sets of well rated corporate bonds recently; Apple (AAPL) 2043 3.85% issued last month and Stanford 2042 4% issued last year. Some investors may also be deliberating long-term bonds for many reasons, though the decision is tough because there is a likelihood (or should I say certainty) low coupon, long-term bonds will lose value as treasury rates go up. Nevertheless some investors may have specific reasons to allocate to low yield, high credit quality fixed income in the next few months — they may be looking for something “safe.”

Many will argue that long-term bonds are completely the opposite right now, and there is some truth to this. The primary reasons are low treasury rates and inflation; the Stanford and Apple bonds do not mature until the early 2040s and the Stanford bonds just dipped under par. Notice how the Stanford bonds compare with the treasuries due in May 2042 and May 2043 below:

Apple 2043 yield 4.44% (rated Aa1) price: $90.23

Stanford 2042 yield 4% (rated Aaa) price: $99.62

2042 0% US treasuries yield 3.59% price: $35.68

2042 3% US treasuries yield 3.36% price: $93.34

2043 0% US treasuries yield 3.55% price: $35.93

2043 2.8% US treasuries yield 3.36% price: $90.76

Bond Prices Falling

Daily treasury yield curve rates have increased to levels we’ve not seen since April 2012.

The 10-year is currently 2.25% up 20.9% since January 2, 2013

The 30-year is currently 3.37% up 10.8% since January 2, 2013

Last year on April 4, 2012 the 10-year was also 2.25%, the 30-year was also 3.37%

In early 2011, the 10-year was 3.36% and dropped 43% to 1.89% by December 2011

Apple 2043

One way to illustrate bond prices’ descent to 52-week lows is to look at Apple’s recent bond offering. Apple’s new 30-year corporate bond offering has a 3.85% coupon, and Aa1 credit rating. Since the offering their price has dropped from $99.41 to $90.23, or 9.2%. Their yield has gone from 3.88% to 4.44% or up14.4%.

The 30-year treasury yield curve rate was 2.96% a month ago when Apple issued their new 2043 bonds, the 30-year is currently 3.37% — that is a 13.8% increase.

As you review the listing consider where the price could go if the 30-year treasury went up to 5%.

credit rating

price

yield

Apple Inc Glbl Bd 3.85% 2043, Make Whole Call (cusip: 037833AL4)

Aa1/AA+

$90.23

4.44%

This bond has a 3.85% coupon, it pays $38.50 a year. As the price on the bond goes down the yield goes up relative to the coupon and the difference between the price and par. Notice the current yield is 4.44%, the coupon represents about 4.26% of the yield, the remaining yield is derived from the difference between par and market price divided by years until maturity. To see the formula check out Yield & Bond Price at Investopedia.

So to answer the question of Apple’s bond price if the 30-year treasury yields 5%. Let’s do some math:

The 30-year treasury is rated Aaa, Apple is Aa1, their bonds yield about 33% more than the 30-year.

If the treasury rate goes to 5% and Apple yields 29% more, that would be 6.45%

The price on the bonds could go to $615 or so, including coupon and difference between market price and par

Let’s compare Stanford, since they are rated Aaa they yield 19% more than the 30-year treasury rate now.

If they yield 17% more than a 5% 30-year treasury their yield would be 5.85%, and price could go to $700

Stanford and Apple would lose about the same amount, $300 — unless either one had a credit rating downgrade. This is just one scenario, conversely it could take a very long time for the 30-year to go to 5% — if it took 10 years, Apple and Stanford would then be judged against the 20-year rate, which is less than the 30-year rate of course. (Keep in mind the 20-yr was at 6% on May 16, 2001.)

Let’s go back and check out when the 30-year treasury rate was last around 5%.

The 30-year treasury fluctuated around 5% in 2007, we’ll get back to this in a few moments. Now let’s look at Stanford’s 2042 bonds issued last year.

Stanford 2042

Stanford University’s acceptance rate for 2012 was 6.6%. Their website shows tuition is $13,750 for undergraduates… a quarter, for a grand total of $55,000 a year. The University has approximately 7,000 undergrads and a $17B endowment.

Keep in mind inflation will continue to affect the value of the dollar. Check out the direction of the 30-year treasury rate, compared to inflation since 1980:

Certainly some investors already think they have an answer to the question: “Should you buy Stanford or Apple bonds?” That answer could be:

I’d pick Apple, because…

I’d pick Stanford, because…

I’d pick neither, because…

Each investor can and will decide what is best for them. Though I will explain my reason for picking a small allocation to Stanford; though it is a very close call. I decided on Stanford primarily because the coupon is greater and they are rated Aaa. The “small allocation” is very important to keep in mind given interest rates are currently at historic lows. Also keep in mind Stanford’s bonds are technically rated higher since S&P downgraded the US credit rating.

If I had to allocate a larger amount, the Apple bonds’ discount is attractive, versus the Stanford bond’s price near par. You see it totally depends on the investor’s precise reason, I want quality income and I’m looking for less of a credit rating risk over the long-term.

Say an investor was going to buy 100 of the Apple bonds, not 2 or 5 of them, there would be a good reason to choose Apple over Stanford; if they wanted the capital gains on the difference between $90,230 and $100,000 in 2043. This investor would need to be able to tolerate the risk, the same way the Stanford investor needs to realize they could also be downgraded.

A Look At One Possible Strategy

The fact is I would only consider either set of these bonds as compliments to zero coupon treasuries and higher yield near term bonds.

Here is an example so you can see. These bonds would generate $222 in taxable income a year:

I’d like more of the zero coupons, though I’d hold off for a better entry point in case rates go up. I’d also like more of the Stanford and Ford bonds; again I hope to review them again next year.

The total percentage these positions represent in the overall example portfolio is 3.5%, so that would be in addition to any other bonds, stocks and cash. The total allocation to bonds should be chosen deliberately, currently I favor a total allocation around 20% – 25% in fixed income, depending on the size of the portfolio. I realize if rates go up a lot their value will go down, though I hope to add more over time.

Inflation Calculator

According to the inflation calculator $1,000 in 2007 had the buying power of $1,121 today. I checked to see what $50 in 2007 would convert to in today’s dollars, it is $56.07. That $6.07 may not seem like much, however consider a bond would require a 5.6% yield to be equivalent to the 2007 5% coupon.

Let’s look at the US Inflation Rate (non seasonally adjusted):

Inflation is very low right now, though investors can not help but notice it was over 5% in the beginning of 2008. Only to collapse to 0% by the beginning of 2009.

Allocate Accordingly

The most important rule of thumb is to allocate accordingly, some investors have said to me they are very worried about investing in certain types of high rated bonds. They know the warning that has been oft repeated about rising interest rates. My response is that the allocation to this type of bond should be measured, to understand the downside. Also it is very important not to put more into a long-term investment, than you would care to lock away for that period of time.

To understand the context check out the 30-year rate in May of 1990. (click to enlarge)

Now consider that $1,000 in 1990 has the buying power of $1,779 today.

Some investors realize this and some do not. Those who sat around investing in 30-year treasuries in 1990 have done incredibly well. As in 270% by 2020 at 9%, instead of 120% by 2042 at 4%. Whereas the treasuries from 1990 handily surpassed the rate of inflation, today higher yielding Stanford bonds (or Apple bonds) might be challenged, especially if held in a taxable non-IRA.

Today most anything that yields near 9% is very speculative. I’ve found a few stocks and bonds that yield around 6 or 7% that I allocate to cautiously; those bonds are far from investment grade.

What About Smaller Investors?

Many newer investors only have $5,000 or less in their portfolios; a recently opened IRA for instance. Clearly these accounts would not even consider $5,000 in a set of bonds, just two bonds could take up 40% of a small $5,000 IRA.

These investors can still gain exposure to high grade corporate bonds and high yield junk bonds through income funds: CEFs and ETFs. Ultimately I believe a goal investors should consider is building up to be able to invest in individual bonds and form a bond ladder. For each investor the point when they can do this is different, it might be once they have $20,000 saved — others might wait until they have more than $100,000.

Keep in mind some investors allocate 60% to equity (stocks) and 40% to fixed income (bonds), while some allocate 0%. I believe 40% may be too much, especially in a very low, and possibly unstable interest rate environment — though I disagree that it should be 0% allocated to fixed income. There is no hurry for smaller investors to jump into bonds, however it might be good to study the field and keep an eye on funds that hold bonds you might like exposure to.

I Googled “Aaa rated bond ETF” to find a fund that holds higher credit quality bonds; one of the top results is iShares Aaa-A Rated Corp Bond ETF (QLTA) you can check out its top holdings at Yahoo!; or its full holdings at iShares. Though I’m not a very big fan of some of the large banks, if I did not have exposure to many high credit quality bonds I would consider this fund.

I Googled “bond ETF holdings Stanford University” and found the iShares Barclays Credit Bond Fund (CFT) holds a small quantity of Stanford’s 2019 bonds, iShares lists the yield to maturity on the Stanford 2019 bonds as 1.8%. Before even considering the ETF, I am going to Morningstar to check its net expense ratio, it is 0.20% which is acceptable; the fund’s 12-month yield is listed as 3.5% (as of 6/11/2013.) So you see there are a few ways to research and find exposure to companies, or institutions that might interest you; though be sure to cross reference information you find on Yahoo! or Morningstar with a given fund’s homepage.

Potential Benefit Of Direct Bond Exposure

While looking for information on Stanford’s bonds I ran across an article with valuable lessons for large and small investors. I invite readers to check out this article about a Stanford professor who was advised to try a certain type of bond fund (leveraged municipal arbitrage strategy funds) that wound up failing.

About 35 retail mutual funds marketed as leveraged municipal arbitrage strategies have failed in recent years… Brokerage firms sold the funds as “higher-yielding alternatives to conventional municipal bond portfolios with little, if any risk”…

Funds using the strategy contended that the market had historically mispriced the yield on municipal bonds compared with taxable bonds. Exploiting that difference to create a profit relied on hedging long-term municipal bond positions with taxable, shorter-term interest-rate swaps. When long-term municipal bond yields rose in 2007 and 2008 faster than short- term rates declined, the strategy failed and portfolios of many funds were liquidated…

You must research investments and consider risks, the Stanford professor was lucky enough to win a ruling, though some investors would definitely not be so lucky. The smaller investor and larger investor can learn a lot from the professor’s ordeal. It goes back to the old saying, “sometimes if you want something done right you’ve got to do it yourself.”

There are many great reasons to trust professionals — I recommend Google searching the name of the firm and “complaints” to see what people say about the professional, also check for experience and performance — you worked hard for your savings, so also take the time to understand the basics. For instance many funds use some sort of leverage, some individuals do too, with margin, this increases risk; in a worst case scenario a portfolio could be wiped out like MF Global was. When these funds fail it is often because the managers gambled more than they had and lost a small percentage of the large bet, however a great percentage of their portfolio’s total value.

Industry studies show that over a long period of time, the benefits of leverage outweigh the drawbacks.

I should note that the ‘drawbacks’ equate to multiple people who were unsuccessful and lost next to everything. Every investment has a certain amount of risk, though most would agree investors in the ill-fated funds would have been better off phasing into blue chip stocks and a variety of well rated bonds. Also if you’ve worked a full career, retire and have a large sum — you might consider dividing your wealth between two professionals, and keeping some for a self managed bond ladder (that can include stocks.) You could either work to generate income for yourself or to allocate to whichever professional is performing better. You do not want to over-diversify, however you also do not want to put all your eggs in one basket.

Clearly the choice between two high rated bonds today is not a simple one. Though this sort of decision making and research is important to investors, small and large. Now is likely not the best time to create a bond ladder all at once, though there is a lot to be said for continuously adding to a collection of bonds. For those of you who believe neither Stanford or Apple bonds are worth the long wait and lower yield now, they may be worth following. Especially if their market prices do go down further and you have a reason to target the early 2040s.

If you have any thoughts on Stanford or Apple’s bonds or this strategy, please leave a comment below.

Disclaimer: This article is not a recommendation to buy or sell, the examples herein are for educational purposes. Please consult a financial adviser to determine proper allocations, if any to individual bonds or bond ladders. I am considering the Stanford 2042 bonds and Apple 2043 bonds.